The Best Opportunity for Safe, Tax-Free Income You’ll See in 2011

If you can ignore one of the media’s biggest sources of hype, you’ll see there’s an amazing opportunity for income investors right now…

But if you’re interested in collecting this income, I encourage you to act soon. It won’t be available for long.

You see, almost every TV show that’s supposed to bring thoughtful, insightful reporting to my living room seems to be filled with either yelling or hyperbole. If it’s not some guy from the NYSE trading floor talking about politics, it’s an ex-jock claiming to know all there is about cancer cures. The claims don’t make sense, and the advice is downright dangerous.

Take, for example, the December 19, 2010 broadcast of 60 Minutes. Wall Street sensation Meredith Whitney – best known for her bearish call in the fall of 2007 on Citigroup – foretold 50-100 “significant” municipal bond defaults that would add up to “hundreds of billions of dollars.” A truly frightening prospect…

[ad#Google Adsense]Since her one great call on Citigroup, she’s soaked up multiple accolades, winning awards like CNBC’s “Power Player of the Year” and joining Fortune’s “50 Most Powerful Women in Business.” The problem is that her claims on 60 Minutes (and similar claims from other analysts) are outlandish… and probably wrong.

But Whitney’s cries (and the market’s panic) have led to an unusual pricing situation in municipal bonds.

As you may know, municipal bonds are loans made to state and municipal governments. To encourage folks to invest in the government, interest received from “munis” is exempt from federal income tax and, in many cases, state and local income taxes.

In normal times, municipal bonds are priced as nearly risk-free investments. But these aren’t normal times. And the fear has driven the yields to levels that don’t make sense. That is handing us an opportunity we need to take…

Assume the likelihood of default on a muni is about the same as on a U.S. Treasury… if the muni pays tax-free income, the rate it pays on the principal should be less than on Treasurys, which are taxable. In other words, Treasurys usually have to pay higher yields than munis to make up for the tax you have to pay on Treasury income.

If you’re in a 50% income tax bracket, paying 7% would yield only 3.5% after tax. In contrast, your tax-exempt bond yielding 4% provides the equivalent of a taxed bond that pays 8%.

Take a look at the chart below showing the yields of the 20-year Treasury (which pays taxable interest) and municipal bonds. The average “spread” between Treasurys and munis has been around 75 basis points (0.75%) going back to 1953. That means munis have traded with 0.75% less interest-rate yield than the comparable U.S. Treasury bond.

Over the past 58 years, municipals traded at a lower interest rate than Treasurys almost 90% of the time. But for the last couple years, the spread has inverted and averaged a negative 120 basis points (-1.2%).

People believe the risk of default to municipal bonds is much higher than it’s ever been. More than during the Korean War, Vietnam, the 1987 Crash, the S&L crisis, or the tech bubble of 2000. In the past two months, the fear has been so rampant, California bonds are more expensive than Mexican bonds.

Since Whitney’s call three months ago, more than $30 billion has exited municipal bond funds. The pace is slowing a bit… But this is exactly the thing the crowd does at exactly the wrong time. They listen to mostly fear-driven hyperbole instead of simply looking at the numbers.

In tomorrow’s essay, I’ll show you how the numbers work out… and why buying municipal bonds at today’s low prices is a great way to collect income right now.

Here’s to our health, wealth, and a great retirement.

— Doc Eifrig

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Source:  Daily Wealth